Strong Earnings, Peak Margins, and 2022 Headwinds, Terry Gardner, CJ Lawrence Market Comment 11.3.21 – YouTube Video & Transcript

In this video, Terry Gardner highlights the strong 3Q21 earnings reports being delivered by S&P 500 companies, questions consensus forecasts for profit margins, and highlights some potential market headwinds for stocks heading into 2022.

Video Transcript

Good afternoon, everyone. It’s Terry Gardner from C.J. Lawrence on Wednesday, November 3rd coming to you from our C.J. Lawrence Midtown Manhattan headquarters. Wanted to come to you today with some brief market commentary. Before I do that, I wanted to address a question that I’ve received a couple of times regarding our old weekly market comments. If you followed our work, you know that we shifted from doing weekly written commentaries to doing periodic, mostly monthly video commentaries. But the question was raised whether or not we still do that work that was behind a lot of those weeklies, and in fact, we do. And we discuss that work here internally at our weekly investment committee meetings. But we’re always happy to share that work if you’re interested. You know, we continue to do things like the Market Monitor, the C.J. Lawrence Market Monitor. We look at the C.J. Lawrence Rule of 20. We look at the Multiple Staircase and do our work on S&P sector shifts and profit margins. So feel free to reach out to us if you would like to see any of that current work that we do.

I want to cover a couple of topics today. First, of course, being the Federal Reserve since today was Fed day. And the Fed decided to announce the tapering program that, I think, was probably largely anticipated by the stock market. In fact, you often see a sell-off in high multiple or technology stocks at the hint of a Fed tapering or a rate increase cycle. But in fact, we didn’t see that today. Big names like Amazon and Microsoft and Alphabet were all up today, despite the fact that the Fed announced that they’re going to curtail their bond purchasing programs in the coming months. So largely, that announcement is now behind us. I think that the markets digested that announcement and largely anticipated it and we can kind of move forward and keep focused on earnings and forward earnings estimates primarily for the S&P 500.

So second point, how are we doing so far in the third quarter? Well, quite well from an earnings perspective. About 75% of the companies in the S&P 500 have reported. Close to 80% of those that have reported have posted an upside surprise to expectations. That’s about a 20-year average or slightly above. The last two quarters saw record upside surprises, but it’s still a very solid result for earnings for the third quarter. Again, earnings are up close to 38, 39% from last year, but it’s important to remember that last year was a COVID quarter, so the comparison is a little skewed. Nonetheless, the leaders were healthcare, technology, and real estate. So technology companies, despite the chatter in the marketplace about pressure being put on technology stocks in the face of higher interest rates, they continue to drive earnings and drive positive earning surprises.

Secondly, we want to talk a little bit about margins because margins may face a headwind as we look out to next year. So far, profit margins have come in at record levels, particularly in the second quarter, now for the third quarter. So the third quarter, depending on how the next 25% of companies that report come in, but it looks like profit margins for the quarter will match or come in close to where they were in the second quarter, which was a record quarter for profit margins. The issue is what do margins look like going forward? And it’s no surprise that with higher labor costs and higher goods costs, transportation costs, the companies are going to be challenged to deliver the same margin improvement that they have over the last couple of quarters. So we want to stay focused on the companies that we think can either pass on price or continue to reduce costs to keep their margins intact and/or continue to expand their margins. And that comes as what we would consider a risk factor when we lookout.

We’re still constructive on the market. There was a couple of risks that we think are worthy of addressing. The first is to the economy and that would be driven by China. As has been well reported in the press, the Chinese economy has been shut down on several occasions due to COVID. They’ve got this zero-tolerance policy whereby if they’ve got some COVID cases they tend to shut down an entire municipality. And that reduces production in those areas, probably feeding into the supply chain issues that the globe is seeing with regard to manufacturing and production of goods and having them shipped around the world. So, that’s something we want to watch.

And it’s been well reported in the press that they’ve got a real estate challenge in China, whereby a lot of the developers have overextended their balance sheets and are now facing challenges in paying bondholders. Evergrande was one of the names that have been most prevalent in the press, but there are others. The big challenge is that close to 15% of the Chinese economy is based on real estate development. And some would suggest that another 15% is related to real estate in some shape or form, whether it’s transportation or providing supplies and materials. So real estate is a critically important component of Chinese GDP.

Additionally, many of the large municipalities in China derive a large portion of their budgets, of their civil budgets by selling real estate to the developers. So as all those things kind of compress and the banks pull back credit, you could see a meaningful slowdown in China and that bears watching. We think that expectations for China may still be a little bit too high. The Chinese government will figure out some way to kind of work through some of these credit issues, but we’re keeping expectations somewhat muted. As the second-largest economy in the world, it’s important that China grows at a reasonably good clip to help sustain global growth. So China’s something that bears watching.

And then, of course, in the markets, we’re always watching interest rates and inflation. Is inflation sticky? Is it transitory? That’s something that’s got to be watched, particularly in its relation to the bond market and what happens with rates across the yield curve. Not necessarily are we not necessarily concerned about the level that rates would rise to, but really how quickly. If you recall past rate cycles where interest rates went up very quickly in a short period of time, the market got spooked, the stock market got spooked. But during periods where rates rose gradually, the market seemed to digest those increases and actually took some positive affirmation from those moves, suggesting that the economy was strong and therefore rates would rise and that would be positive for corporate profits in the end.

So I’d wrap up by saying we’re still constructive on the stock market, but we’re increasingly selective looking out into 2022. And we’re remaining focused on companies that can grow their earnings faster than their multiples could potentially compress. So if interest rates and inflation are going to rise, it’s likely the market multiple is going to compress, relative multiples will compress. So we want to own companies that have the ability to drive earnings regardless of that multiple compression and offset it. And that’s where we’re staying focused.

Again, if you’d like to see any of our work, feel free to give us a ring at 212-888-6403 or shoot me an email at And have a great evening. Thanks.

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